Equity Prices. The Missing Link between Income Inequality and Financial Crises?

An empirical investigation

Master's Thesis , 2013 , 59 Pages , Grade: 8,5 (out of 10)

Economics - Other

The question that has motivated this paper is whether financial crises and income inequality are systematically related. The long rise of inequality in many advanced countries prior to the Great Recession has inspired several authors (e.g. Fitoussi & Saraceno, 2010; Rajan, 2011; Stiglitz, 2009; Stockhammer, 2012) to argue that inequality is a root cause of this crisis. The suppressing effect of inequality on aggregate demand, these authors argue, has prompted many governments to adopt a debt-led growth model, which relies on over-borrowed, over-consuming households. Additionally, households on their own might respond to growing inequality by saving less, or borrowing more, in order to maintain a standard of living that they deem acceptable (Frank, Levine & Dijk, 2010; Kumhof & Rancière, 2010). This view thus sees inequality as a causal factor for rising debt and credit levels. But while debt and credit are the best predictors of financial crises (Jordà, Schularick & Taylor, 2011) the effect of income inequality on debt seems to be too weak to be considered a root cause (see, e.g. Bordo & Meissner, 2012). The co-occurrence of financial crises and periods of rising inequality may thus be caused by a third factor.

This study introduces equity prices as a possible explanation. Firstly, equity prices affect several sources of income with little delay: equity investments often pay dividends; they can potentially be resold at a capital gain; and the performance of company stocks might determine the compensation of top executives in financial and non-financial industries. Secondly, asset prices in general are an indicator of financial stability due to their systematic and interdependent relation to credit (Mendoza and Terrones, 2008), and they reveal a systematic boom-bust pattern around banking crises (Reinhart & Rogoff, 2009). The goal of this study is hence to examine these two properties of equity prices in more detail and connect them in order to establish a theoretical framework that explains why financial crises are often associated with a preceding rise in income inequality. Beyond this, the link between equity prices and top income shares will be empirically tested utilizing a panel of 18 advanced economies between 1913 and 2011. The significant results are then used to analyze the implications for inequality of income in times of crises.

Inhaltsverzeichnis (Table of Contents)

• 1. Introduction
• 2. A Theoretical Framework
  • 2.1. Asset Prices, Credit and Financial Crises
  • 2.2. Asset Prices and Income Inequality
  • 2.3. Income Inequality and Credit Growth
• 3. Asset Prices and their Relation to Credit Growth and Financial Risk
  • 3.1. Collateral
  • 3.2. Wealth Effect
  • 3.3. Bank Capital
  • 3.4. Excessive Credit
  • 3.5. Interest Rates
• 4. Income Inequality and Equity Prices
  • 4.1. Wage Determination
  • 4.2 Capital Income and Capital Gains
• 5. Inequality as a Cause of Financial Distress? An Assessment of Recent Literature.
• 6. An Econometric Model: Determinants of Income Inequality
  • 6.1. Data Description and Pretesting
  • 6.2. Estimator Choice and Results
  • 6.3. Robustness Tests
  • 6.4. Implications for the Relationship between Income Inequality and Banking Crises
• 7. Conclusion

Zielsetzung und Themenschwerpunkte (Objectives and Key Themes)

This paper examines the systematic relationship between financial crises and income inequality, arguing that equity price booms, which precede financial crises, generate income disproportionately for the top of the income distribution. The study aims to establish a theoretical framework that explains this relationship, analyze the implications of the findings for inequality during times of crises, and empirically test the link between equity prices and top income shares using a panel of 18 advanced economies between 1913 and 2011.

• The relationship between financial crises and income inequality.
• The role of equity price booms in generating income inequality.
• The impact of equity prices on various income sources, including dividends, capital gains, and executive compensation.
• The link between equity prices and financial stability.
• The empirical analysis of the relationship between equity prices and top income shares.

Zusammenfassung der Kapitel (Chapter Summaries)

• Chapter 1: Introduction This chapter introduces the research question and the motivation behind it. It discusses the link between income inequality, debt-led growth, and financial crises. The chapter highlights the role of asset price booms and busts in financial crises and proposes equity prices as a potential link between crises and income inequality.
• Chapter 2: A Theoretical Framework This chapter presents the theoretical framework that links income inequality and financial crises through equity prices. It argues that equity price booms disproportionately benefit the top of the income distribution, contributing to income inequality. The chapter also discusses the relationship between asset prices, credit, and financial crises.
• Chapter 3: Asset Prices and their Relation to Credit Growth and Financial Risk This chapter explores the relationship between asset prices, credit growth, and financial risk. It examines how factors like collateral, wealth effects, bank capital, excessive credit, and interest rates influence this relationship.
• Chapter 4: Income Inequality and Equity Prices This chapter focuses on the relationship between equity prices and income inequality. It examines how equity prices affect different sources of income, including dividends, capital gains, and executive compensation. The chapter argues that equity price booms can lead to increased income inequality.
• Chapter 5: Inequality as a Cause of Financial Distress? An Assessment of Recent Literature This chapter critically assesses the potential causal relationship running from income inequality to financial crises, drawing on recent literature. It analyzes the arguments and evidence surrounding this relationship.
• Chapter 6: An Econometric Model: Determinants of Income Inequality This chapter presents an econometric model to analyze the link between equity prices and income inequality. It describes the dataset used, tests the proposed relationship, and discusses the implications and limitations of the findings.

Schlüsselwörter (Keywords)

This study focuses on the relationship between income inequality and financial crises, exploring the role of equity prices as a potential link. The study investigates the impact of equity price booms on top income shares, analyzes the determinants of income inequality, and examines the implications of the findings for financial stability and crisis prevention. Key themes include income inequality, financial crises, equity prices, asset prices, credit growth, and financial risk.

• College: Maastricht University
• Grade: 8,5 (out of 10)
• Author: Matthias Runkel (Author)
• Publication Year: 2013
• Pages: 59
• Catalog Number: V285240
• ISBN (eBook): 9783656851882
• ISBN (Book): 9783656851899
• Language: English
• Tags: income inequality, financial crises, Great Recession, asset prices, equity prices, credit growth, determinants of income inequality, stock market, banking crises, wealth effect, collateral, wage determination